From SoCal Real Estate’s August 2018 issue
Breakfast at the BMC Takes on Taxes
The Tax Cuts and Jobs Act of 2017 raised a lot of questions for real estate funds, companies, and investors as they planned for the future of their business. The recent “Breakfast at the BMC” event at the Alexandria at Torrey Pines in San Diego, titled “Corporate and Individual Impacts of the Tax Cuts and Jobs Act of 2017 and How to React to It,” presented by the Burnham-Moores Center for Real Estate at the University of San Diego School of Business, strived to answer many of those questions.
Cory Grant, founding partner and shareholder at Grant Hinkle and Jacobs, said, according to a recent survey of businesses, retention of employees and taxes are the key issues for business owners today. Retaining key talent increases a business’s value up to sixfold. The new tax laws can impact this retention.
James Gergurich, a tax principal in the San Diego office of KPMG, explained that the Act changed the tax rates by creating new tax brackets—10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent and 37 percent—with no change to the capital-gains or investment-income tax. Personal exemptions were repealed, and the standard deduction increased, with the individual deduction limited to $10,000 for state income and property taxes.
Grant said there will be a lot of changes to come with the shakeout of the new tax code in the net six to 18 months, “so you want to plan flexibly.”
The speakers said deciding whether to set up your business with a pass-through, corporate, or REIT structure requires a considerable amount of evaluation, since the new code set a lot of parts in motion. Certain definitions—such a professional-services income—are narrower, creating questions and complications. “It will take time before there is much more clarity on this,” said Russ Broadway, a tax-account leader based in EY’s San Diego office.
As for California itself, many companies are considering moving out of state because of the high personal and corporate tax rates. Broadway said one issue to consider is if the investors themselves are based in California; if not, the tax rules state where they are based may apply. Gergurich added that companies should be aware that in this case, both states could have a claim to taxes. Broadway advised thinking through the nature of income-state tax considerations and consulting a tax advisor because the current situation is not a normal course.
Grant pointed out that one thing companies should consider in retaining key talent in a way that’s tax efficient for both the firm and its employees is the value of an employee’s specialized knowledge in a particular subject. It may be worthwhile to set aside a pool of funds as incentive for that employee to remain with the firm for a set period of time rather than risk losing them to a competitor offering a better compensation package.
Looking specifically at real estate companies, Broadway said real estate funds are getting a lot more questions from investors now because of the new tax laws than they had in the past, and Gergurich added that foreign investors are also seeking more guidance on structure and how the changes will impact them. He said it’s important to keep in mind the impact your tax decisions will have on various stakeholders, including tenants, investors and nonprofit sources of capital, and institutions and private equity. “It’s not just how it impacts your bottom line, but also the other constituencies.”
NAIOP San Diego Covers Capital Markets
The economic expansion we have experienced nationally since the recession has been long and slow — 9.5 years, to be exact — but San Diego’s real estate fundamentals have been in check, which bodes well for the region, said Brian Russell, SVP at Eastdil Secured, during NAIOP San Diego’s recent lunch event, “Capital Markets and How San Diego Will Be Impacted.” The event presented national trends and predictions and how they impact our local region.Russell said supply is under control, and the cycle still has legs, with room for both pricing and rent growth.
Moderator Dennis Cruzan, founding partner of locally based developer Cruzan, asked if companies are still growing in the area enough to make a difference in the real estate market, and Aldon Cole, senior managing director of HFF LP, said the growth has been disciplined and companies are not overstaffed.
Russell said what makes this cycle different from other cycles is that overseas investment money from markets like Hong Kong and Singapore is finding gateway cities like L.A. and San Francisco to be saturated and offering lower yields, so money from those investors is trickling down to the secondary markets like San Diego. He added that the yield environment has pushed values for all general investment asset classes, just less for CRE.
Cole added that CRE as an asset class has continued to be sought by investors who want better yield than other asset types have provided, validating both the asset class and the private real estate investment market.
Moving on to discuss interest rates, Cole said the availability of capital is more meaningful to the real estate industry than where interest rates are at any given time. He said there is some headroom for growth in this area despite where we are on values. Russell added that where lenders believe we are in meaningful rent growth will determine their willingness to underwrite and at what level.
In discussing cap rates, Cole said his firm has seen that “to maintain value, NOI growth needs to be between 15 percent and 17 percent, which is an interesting dynamic.” He added, “The interest-rate conversation is front and center for the first time in a while,” and he said interest rates are impacting investment behavior.
Cruzan asked the panel and attendees if a 50- to 75-bps bump in interest rates would show a cap-rate increase, and while the audience didn’t bite, Cole said, “I do.” He added that if owners are thinking of doing anything finance-wise, refinancing would be a wise thing to do now.
Russell noted that as of Q1 2018, there was $266 billion in closed-end private real estate dry powder looking for deals — the highest amount in record — which indicates just how ready the market is to pounce on available properties and real estate investment opportunities.
Cruzan asked the panel if investment advisors could be eliminated because yields are so low, and Russell admitted that he is seeing more direct investment, while Cole said dollars will continue to be concentrated on core assets. He added that we may not see much growth, but slightly higher rates, and since we have shown good discipline and there is no oversupply, “I feel as though we’re in a pretty good place from an industry standpoint. We haven’t gotten ahead of our skis.” Institutional allocations are increasing, further validating real estate as an asset class, he said.
This year, everyone is anticipating higher interest rates, but they may not be as prolific or profound as we had thought, Cole pointed out. In addition, real estate continues to be underallocated. Russell said the benchmark is 10 percent, whereas in the past it was 9.5 percent.
Cole also pointed out that the pace of fundraising has slowed significantly, mostly due to investors’ lack ability to invest. “Funds with a Roman numeral eight or in the double digits are getting the funds, but there are not a lot of new funds coming into the market.”
Total originations increased through 2017, and HFF’s debt business was up 30 percent last year, Cole said. CMBS market share was up in 2017, and agency participation is even after the post-recession bailout.
Russell summed up what the market wants: industrial of all types, “bite-sized” core assets of smaller size but in good markets, core assets with “personality” (Main & Main, but a little hairy, a core product with the risk of core-plus), value-add multifamily, value-add office in strong markets, and homogeneous platforms and portfolios. What’s not pricing efficiently? Retail, except for premier product; most suburban office; and very large commodity assets, particularly in East Coast and Midwest markets.